Danger Lurks Behind These Big Yields

If you're trying to get more income from your portfolio, you're not alone. It's a dog-eat-dog world in the income-investing arena, and if you don't understand how a particular investment produces the income it pays to its investors, then you could be in for a big shock when something goes wrong in the future.

Looking beyond the obviousFortunately, if you're willing to take stock market risk with your savings, there's no shortage of interesting opportunities to generate substantial income by buying dividend stocks. Even cream-of-the-crop blue-chip dividend stocks pay better yields than you'll get from Treasury bonds and bank CDs.

Still, because many investors got used to the 4%-5% that used to be dependable yields on ultra-safe investments, it's tempting to go beyond blue-chip stocks to try to take advantage of truly massive dividend yields. One place where you can find some tempting yields is in the closed-end fund arena -- but to generate those yields, closed-end funds take on risks that you need to understand fully.

Why closed-ends are so attractiveThere's no secret why investors gravitate to closed-end funds, given the returns and yields they've given their shareholders lately. Not only has Pimco High-Income Fund (NYS: PHK) delivered yields of around 10% on its distributions, it has also seen its share price rise by 15% over the past two years. Similarly, Pimco Income Strategy II (NYS: PFN) has boasted almost the same jump in shares while paying about an 8% yield -- and it just hiked its monthly distribution by 23% to boot.

But rather than simply just buying shares, your first task in looking more deeply at these funds should be to find out what's behind those powerful yields. One of the first things you'll discover is that many closed-end funds use the same tactic that Annaly Capital (NYS: NLY) uses to boost its gains in the mortgage REIT arena: they use leverage. By issuing preferred shares, these Pimco closed-ends use leverage to increase their payouts, as the funds can borrow at cheaper rates while earning higher returns on the corporate bonds that are the primary components of their portfolios.

You can find other funds doing largely the same thing with dividend-stock investments. Gabelli Equity Trust (NYS: GAB) owns many well-known stock names, many of which pay solid dividends. But by borrowing more than $300 million on top of its $975 million in common assets, the Gabelli closed-end fund is able to invest more money in stocks, giving itself the higher potential rewards -- and risk -- from a leveraged investment.

As long as interest rates stay the way they are, leverage likely won't come back to bite these funds. But if rates start to rise, shareholders will likely find them more volatile than their more conventional fund peers.

Paying you back with your own moneyThe other thing you have to watch out for with closed-end funds is what the source of the distribution actually is. With most dividend stocks, you can gain confidence from knowing that the underlying business generates the profits and cash flow to cover dividend payments.

But some closed-end funds end up returning invested capital back to shareholders through distributions. For instance, with the Gabelli closed-end, all of its distributions over the past 12 months have been classified as return of capital. Although Pimco Income Strategy II's distributions all come from income, the past eight months of payouts from Pimco High-Income included a substantial portion of returned shareholder capital -- more than a quarter.

For investors in master limited partnerships, return of capital may seem familiar as a tax-reduction technique. Yet when Inergy (NYS: NRGY) and many of its MLP peers pay distributions, some of them are considered returns of capital because of depreciation from the MLP's assets. By contrast, closed-end funds simply choose to return capital in order to boost their apparent yields -- as some shareholders never realize that the assets within the fund are slowly waning in value.

Don't get fooled againPerhaps worst of all is when closed-end funds trade at values well above what their assets are worth. That's been the case for Pimco High Income for a long time; it currently trades at a 70% premium to its net asset value.

Plenty of investors are starving for income right now. But don't let high-yielding closed-end funds confuse you with their high yields. Getting those big payouts often involves taking more risk than they're worth.

Instead of looking at dangerous high-yield investments, think more about stocks you can stick with for the long haul. We've got three ideas we like in the Motley Fool's special report on long-term investing -- so click here and start reading your free copy right now.